Loan Monitoring: Comfort in a Crisis

Pledged collateral shouldn't be relied upon to ensure loan repayment. Instead, regular cash flow monitoring is the only way lenders can understand their borrowers' financial state and to be empowered to take action before it may be too late to recover.

Top lenders rely upon quarterly monitoring but with the inevitable delay it can be 5 months for a lender to realize that there is a problem. By that time it may be too late. Leading edge banks are now turning to technology to access borrower bank activity to actually monitor cash.

One lesson that can be drawn from the current credit crisis is that a lender can be beset with horrendous loan losses even with the best underwriting. Why? There are predominantly two reasons: First, the backstop to effective underwriting is collateral. In a downturn with the depth and breadth of the current one, the value of pledged assets fell to historic lows. This created a disconnect to their market value at the time of underwriting. Second, if a lender's first notice of slipping performance is a monetary default, the borrower may have dug such a financial hole by that point, that no viable remediation options may exist. Given these reasons, more effective loan monitoring is required to better support loan underwriting.

Effective loan monitoring does more than just reduce loan losses. The capability to effectively monitor a loan can reduce a lender's reliance on collateral. This is especially important in restaurant financing. With the value of restaurant equipment at historic lows, business assets will often not sufficiently collateralize a restaurant loan. On the bright side, if a lender is considering a remodeling or expansion loan for a business with solid cash flow performance even in this down economy, loan monitoring enables them to focus more of the financing decision on the strength of the borrower's business than the strength of the assets to be pledged. For any loan, effective loan monitoring can allow for the safe reduction of collateral as stable cash flows are achieved.

To avoid finding out about a borrower's potential monetary default too late, the current best practice for loan monitoring is quarterly financial statement analysis. Whether arrived at intuitively or via analysis, lenders have correctly determined that quarterly financial statement analysis is not cost effective at lower loan amounts.

To be sure, an accurate cost/benefit analysis requires the lender to determine the value of the analyzed data as an early warning tool. This valuation must consider the timeliness, accuracy, and effectiveness of the information.

Quarterly financial statements take time to compile and the process can only begin when all the data has been collected, after the end of the period. Lenders who require quarterly financial statements often give borrowers 30-90 days to submit the financial statements. If performance declines in the first month of the quarter, it could be 3-5 months before the lender is aware of a problem. In this current economic downturn, many borrowers failed in-between reports. Timeliness is inversely related to the size of the borrower. A large firm can often survive a temporary downturn. Smaller borrowers, who are more susceptible to a temporary downturn, are monitored less due to the cost of quarterly financial statement analysis.

While timeliness is affected by the collection of data, accuracy can be affected by many variables. Improper categorization, bad use of an accounting convention, use of the wrong accounting convention, posting errors, and mathematical errors can all lead to inaccurate results. When an accountant reviews financial statements, they will only offer an opinion on whether they "materially represent" the financial condition of the firm - not whether they are accurate.

Leading edge banks are now turning to a technological solution for the pressing problem of effective monitoring. Lenders can now securely access the borrower's bank account data to track receipts and expenses on a monthly basis. As long a lender secures the borrower's permission, actual cash flow can be monitored. And by accessing accurate data months earlier than quarterly financial statement analysis - at a fraction of the cost - lenders can maximize remediation options when it still matters. Working with the borrower, the lender needs to model receipts and disbursements into revenue and expense categories. The real cash data then can be instantly categorized and analyzed to measure the borrower's health. Beyond reducing the reliance on collateral, cash flow monitoring minimizes the impairment that results from delayed discovery of a problem.